How Credit Scores Work

Introduction

We apply for credit for many reasons -- maybe it's to buy a new car, house, computer,
or get a student loan. Did you know, however, that there is a special number that
can determine whether you can do these things, or at least how much it will cost
you? Your credit score is a three-digit number that can do just that.

How can a single number be meaningful enough to determine whether you can buy a
house or car? A credit report contains a history of how you've paid your bills,
how much open credit you have, and anything else that would affect your creditworthiness.
Your credit score boils down all of that information into a three-digit number.

In this article, we'll find out how this formerly secret number is used and how
it affects how much you pay for credit, insurance and other life necessities.

What is a Credit Score?

A credit score is a number that is calculated based on your credit history to give
lenders a simpler "lend/don't lend" answer for people who are applying for credit
or loans. This number helps the lender identify the level of risk they may be taking
if they lend to someone. While the same end result can come through reviewing the
actual credit report (which lenders usually do), the credit score is quicker and
less subjective.

The system awards points based on information in the credit report, and the
resulting score is compared to that of other consumers with similar profiles. With
this information, lenders can predict how likely someone is to repay a loan and
make payments on time. It's the credit score that makes it possible to get instant
credit at places like electronics stores and department stores.

Although there are several scoring methods, the score most commonly used by lenders
is known as a FICO because of its origins with
Fair Isaac and Company. Fair Isaac is an independent company that came up
with the scoring method and software used by
banks and lenders, insurers and other businesses. Each of the three major
credit bureaus (Experian, Equifax and TransUnion) worked with Fair Isaac in the
early 1980's to come up with the scoring method.

The three national credit bureaus each have their own version of the FICO score
with their own names. Equifax has the Beacon system, TransUnion has the Empirica
system, and Experian has the Experian/Fair Isaac system. Each is based on the original
Fair Isaac FICO scoring method and produces equivalent numerical results for any
given credit report. Some lenders also have their own scoring methods. Other scoring
methods may include information such as your income or how long you've been at the
same job.

Calculating the Score

Think of your credit score like you would a grade in school. A teacher calculates
grades by taking scores from tests, homework, attendance and anything else they
want to use, weighting each one according to importance in order to come up with
a final single number (or letter) score. Your credit score is calculated in a very
similar manner. Instead of using the scores from pop quizzes and reports you wrote,
it uses the information in your credit report.

The number itself can range from 300 to 900. The formula for exactly how
the score is calculated is proprietary information and owned by Fair Isaac. Here,
however, is an approximate breakdown of how it is determined:

35% of the score is based on your payment history. This makes sense since
one of the primary reasons a lender wants to see the score is to find out if (and
how timely) you pay your bills. The score is affected by how many bills have been
paid late, how many were sent out for collection, any
bankruptcies, etc. When these things happened also comes into play.
The more recent, the worse it will be for your overall score.

30% of the score is based on outstanding debt. How much do you owe on car
or home loans? How many credit
cards do you have that are at their credit limits? The more cards you have
at their limits, the lower your score will be. The rule of thumb is to keep your
card balances at 25% or less of their limits.

15% of the score is based on the length of time you've had credit. The longer
you've had established credit, the better it is for your overall credit score. Why?
Because more information about your past payment history gives a more accurate prediction
of your future actions.

10% of the score is based on the number of inquiries on your report. If you've
applied for a lot of credit cards or loans, you will have a lot of inquiries on
your credit report. These are bad for your score because they indicate that you
may be in some kind of financial trouble or may be taking on a lot of debt (even
if you haven't used the cards or gotten the loans). The more recent these inquiries
are, the worse for your credit score. FICO scores only count inquiries from the
past year.

10% of the score is based on the types of credit you currently have. The
number of loans and available credit from credit cards you have makes a difference.
There is no magic number or combination of types of accounts that you shouldn't
have. These actually come more into play if there isn't as much other information
on your credit report on which to base the score.

This information is compared to the credit performance of other consumers
with similar histories and profiles.

Your Score Affects...

Your credit score doesn't just affect whether or not you get a loan; it also affects
how much that loan is going to cost you. As your credit score increases, your credit
risk decreases. This means your interest rate decreases.

This chart shows an example of how interest rates for a car loan can vary based
on your credit score:

FICO® Score

Auto Loans

500-589

590-624

625-659

660-689

690-719

720-850

36-month new auto loan

18.597

16.206

12.225

9.498

7.386

6.674

48-month new auto loan

18.598

16.206

12.226

9.500

7.390

6.678

Source: myFICO.com

There are other factors that influence the interest rate you get for a loan besides
your credit score. Things like the type of property you are using the loan to buy,
how much of your own money (equity) is going into it, the costs the lender has to
make the loan, etc.

Who else uses credit scores?

In addition to banks and lenders, there are landlords, merchants, employers and
insurance companies jumping on the credit score bandwagon. Of all of these, the
fact that insurance rates are being determined by credit scores is causing consumers
the most alarm. To most, it seems that your credit history and your driving record
have little in common. Insurers, on the other hand, have found that using credit
scores to predict how likely someone is to pay premiums has helped them cut their
losses. They don't use the same score that banks and lenders use, however. They
use a slightly different formula for their calculations and actually call it an
"insurance score."

Insurers' use of credit histories to determine rates is under scrutiny nationwide.
Many states are passing laws restricting this practice. Washington, Utah, Idaho
and Maryland have already done so, and 20 more states are considering it. Check
your state’s department of insurance Web site to see where your state stands on
the issue http://www.naic.org/state_contacts/sid_websites.jsp